Goodbye, Debit Card Fees. What's Next?

A few weeks ago, almost every major bank had plans to begin charging a monthly fee on those who used a debit card. It didn't take long for the entire industry to about-face: Every major bank has now dropped those plans after customers stomped their feet in loud disapproval.

Some are lauding the banks' retreat as a win for consumers. "BofA canceling debit card fees is a sign that transparency and competition are coming back to the banking industry," Senator Dick Durbin tweeted last week.

I'm not so sure.

For some background, basic checking has been free or near-free for years because banks could generate income through so-called interchange fees when customers used their debit cards. These fees are borne by the merchant, so checking account customers never actually saw them. That provided the impression that checking was free, when it actually wasn't: Banks could make money off checking by generating fees under the table -- so to speak, out of sight and out of mind.

That all changed when Congress instituted a new law last month that drastically clamped down on banks' ability to generate interchange income from debit cards. To make up for the lost revenue, most for-profit banks began experimenting with monthly debit-card fees. Bank of America's (NYS: BAC) plan, which received the most attention, proposed to charge any customer who used their debit card $5 per month. JPMorgan Chase (NYS: JPM) , Wells Fargo (NYS: WFC) , Citigroup (NYS: C) , SunTrust (NYS: STI) and others all had similar plans -- until recently.

The most important thing to understand in this debate is that banks have overhead costs when providing checking accounts. Supplying ATMs, paying FDIC insurance premiums, building bricks-and-mortar branches, printing account statements, staffing call centers, running back-office check processing -- all of that stuff costs money. According to the American Bankers Association, overhead on an average checking account is $250 to $300 per year. Moebs Services, a private research firm, estimates that it costs large banks as much as $450 a year in overhead to maintain a checking account.

Many assume that banks make up for these costs by lending your money out. But that only covers a tiny fraction of overhead, especially on small accounts. Bank of America's net interest margin in 2010 was 2.8%, for example. With those margins, the interest revenue generated off a customer who keeps, say, $500 in their checking account is negligible, unlikely to even cover the cost of issuing month account statements. For small customers, there has to be some sort of fee-based revenue to cover expenses.

In the past, interchange fees on debit card purchases and overdraft fees were how banks made issuing checking account worth their while. In 2008, for example, Bank of America earned an after-tax profit of $5.6 billion on deposits, fueled by $6.8 billion in fee-based income. It would have lost more than $1 billion issuing checking accounts without those fees. Interest income wouldn't have covered overhead costs.

The problem with recent regulations limiting overdraft fees and debit card interchange is that the cost structure of issuing checking accounts didn't change -- overhead costs didn't go down. Banks can't just sit still and watch tens of billions of dollars in revenue disappear. They had to seek new ways to cover costs.

Now that banks have backed away from debit card fees amid consumer uproar, the question is where and how -- not if -- they will seek new ways to extract revenue out of customers. As Bloomberg reported:

"We will continue to initiate actions to mitigate lost revenue where and whenever possible," [a Bank of America spokesperson said] yesterday in an interview ... Lenders will "find more subtle ways to make up for this lost revenue, increases that may fly under the radar," said Bill Hardekopf, CEO of Birmingham, Alabama-based research firm LowCards.com. "Banks may increase existing fees or raise the introductory interest rates on credit cards."

What's unfortunate is that a monthly fee for those using debit cards actually wasn't a bad idea. The fee was, in a sense, optional -- you could still have free checking so long as you didn't use a debit card. Most important, it was transparent. Those using a debit card would have seen the same fee every month on their statement. They would have been aware of how much their checking account really cost. That's when capitalism works best; when everyone knows exactly what's going on.

Instead, it looks like we're going to go back the days where checking accounts appear to be free, but will be subsidized by a host of under-the-table fees customers are largely unaware of. If this is a win for consumers, count me out -- or better yet, get me to a credit union.